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Buffett’s Alpha

We control for risk exposures in measuring the funds' ability to outperform following the four factor approach advocated by Carhart (1997). We start with a Pan-European four-factor model. The four factors include a market risk factor, measured by the MSCI Europe total return index minus the one-month Euribor short rate; a size factor (small minus big, or SMB) that captures the di erence between returns on the Europe STOXX Small Cap Return Index and the Europe STOXX Large Cap Return Index; a value factor (high minus low, or HML) computed as the di erence between European value and growth portfolios. Finally, our momentum factor is constructed from the following. | Buffett s Alpha Andrea Frazzini David Kabiller and Lasse H. Pedersen First Draft May 3 2012 This draft August 29 2012 Comments Welcome Abstract Berkshire Hathaway has a higher Sharpe ratio than any stock or mutual fund with a history of more than 30 years and Berkshire has a significant alpha to traditional risk factors. However we find that the alpha become statistically insignificant when controlling for exposures to Betting-Against-Beta and quality factors. We estimate that Berkshire s average leverage is about 1.6-to-1 and that it relies on unusually low-cost and stable sources of financing. Berkshire s returns can thus largely be explained by the use of leverage combined with a focus on cheap safe quality stocks. We find that Berkshire s portfolio of publicly-traded stocks outperform private companies suggesting that Buffett s returns are more due to stock selection than to a direct effect on management. Andrea Frazzini and David Kabiller are at AQR Capital Management Two Greenwich Plaza Greenwich CT 06830 e-mail andrea.frazzini@aqr.com web http www.econ.yale.edu af227 . Lasse H. Pedersen is at New York University Copenhagen Business School AQR Capital Management CEPR FRIC and NBER 44 West Fourth Street NY 10012-1126 e-mail lpederse@stern.nyu.edu web http www.stern.nyu.edu lpederse . We thank Cliff Asness Aaron Brown John Howard Ronen Israel Sarah Jiang and Scott Richardson for helpful comments and discussions. We are grateful to Nigel Dally for providing us with historical 10-K filings. Buffett s Alpha 1 1. Introduction The Secret Behind the Oracle s Alpha While much has been said and written about Warren Buffett and his investment style there has been little rigorous empirical analysis that explains his performance. Every investor has a view on how Buffett has done it but we seek the answer via a thorough empirical analysis in light of some of the latest research on the drivers of stock market returns.1 Buffett s record is remarkable in many ways but just .